Locally awesome

Behavioralists question three “fundamental principles” of the neoclassical account.

The first, downward sloping demand curves (i.e. price responsiveness) can hold true without the stronger version that this is an optimal behavior. Indeed, even “stupid” buyers and sellers can clear markets. (Simon, 1996, at 33) The second, that opportunity costs are equal to out-of-pocket costs (and sunk costs are ignored), is belied by research that shows that people are unwilling to buy Super Bowl tickets at the market price, but would also be unwilling to sell them (if they had them) at the market price. In other words, people set their own idiosyncratic values in markets that don’t have obvious cash prices defined. (Jolls et al., 1998, at 1482, 1484) The third, that resources tend to flow to their most valuable uses, is undermined by observation of the endowment effect.

Behavioralists have considered four of the “well-known successes of economics”: (1) the inverse correlation between price ceilings and queues; (2) the inverse correlation between rent control and the stock of housing; (3) the positive correlation in financial markets between risk and expected return; and (4) the relation between futures prices and spot-market prices. They note that the first three simply predict the direction but not the magnitude of change. For instance, the third example notes that stocks tend to be riskier and thus have higher prices than relatively riskless bonds. Yet the theory says little about the impressive magnitude of this difference, or the equity premium puzzle. As for the fourth example, the neoclassicals’ prediction of the magnitude of the relationship between futures prices and spot-market prices is more accurate, but this market is characterized by arbitrage, reputation effects, and learning effects – which are not generally applicable to human behavior.[i] (Jolls et al., 1998, at 1485-1486)

Indeed, behavioralists assert that neoclassical economics has false parsimony and incorrect predictions. For instance, the goal of neoclassical work

“…is to provide a unitary theory of behavior, a goal which may be impossible to achieve. By itself the notion of ‘rationality’ (the centerpiece of traditional analysis) is not a theory; to generate predictions it must be more fully specified, often through the use of auxiliary assumptions. Indeed, the term ‘rationality’ is highly ambiguous and can be used to mean many things. A person might be deemed rational if her behavior (1) conforms to the axioms of expected utility theory; (2) is responsive to incentives, that is, if the actor changes her behavior when the costs and benefits are altered; (3) is internally consistent; (4) promotes her own welfare; or (5) is effective in achieving her goals, whatever the relationship between those goals and her actual welfare.”

Utility theory is simply false, and people often take steps that are not internally consistent, and do not promote their welfare or achieve their goals. As for incentive responsiveness, it is difficult to use this concept to predict outcomes without first knowing what costs and benefits are to the individual or unit in question. (Jolls et al., 1998, at 1488)

Even within that most classic of economic unit (i.e. the firm), neoclassicals are at a loss to explain the existence of “incomplete contracts,” i.e. how and why employees take actions that are not specified. New institutional economics explains this through economizing on transactions costs, but is unable to explain why employees do things that they are never told to do. Simon states that organizations are characterized by systems of authority, reward, loyalty and coordination. Even when free-rider theory might predict that employees will not help their firm succeed (if they themselves are not rewarded for marginal effort), Simon suggests that humans have evolved traits like docility that on average improve our collective fitness. (Simon, 1991, at 30, 34-36) But any “maximizing” is purely local: our evolution cannot be said to the best it can be, only that it fits our environment. In Darwinism, genetic mutation and chromosome crossover are the generators, and natural selection the test. In contrast, in economics, the processes that lead to change and variance in business algorithms’ (which can be imported across firms) are the generators, and profitability and growth rates the fitness tests. (Simon, 1996, at 46-48)